When the 1,318-kilometer Beijing-Shanghai high-speed railway line is completed in 2011, it will be the crown jewel of China’s infrastructure splurge. The transport link will feature the world’s longest bridge, connecting the 164 kilometers between Danyang and Kunshan in Jiangsu province, and when completed, it will transport 220,000 passengers every day.
For all its glamor, however, the Beijing-Shanghai line will be just one small part of the 42,000 kilometers of new railway lines planned between 2009 and 2020.
All this construction has supported China’s domestic growth during a time of global economic weakness, employing millions of workers and creating demand for those building blocks of civilization, cement and steel. Rail construction alone generated 20 million tons of steel and 120 million tons of cement demand in 2009 – enough to build 181 Bird’s Nest stadiums and 11 Three Gorges Dams. Nationally, infrastructure development accounts for as much as 30% of China’s cement demand, and 15-20% of its hunger for steel.
Past its prime?
The hunger may not last. China’s demand for infrastructure is already peaking, and despite the country’s continuing need for enormous amounts of cement and steel, both areas are wracked by oversupply. Zuo Feng, CEO of website Digital Cement, described the current period as the "golden age" of the Chinese cement industry, but noted that construction in eastern provinces is already hitting a saturation point. Others agree.
"There’s a peak when the cumulative consumption gets to about 20 tons per capita – perhaps in China it will be higher than that, and maybe Chinese buildings won’t last as long – but in the east coast markets, it’s reaching that kind of level," said Ian Riley, China vice president of global cement supplier Holcim and vice president of Chinese firm Huaxin Cement.
Infrastructure construction is increasingly extending to China’s second- and third-tier cities, and China Development Bank will offer US$3 billion in infrastructure loans to the western region of Xinjiang this year. Even these new sources of demand, however, will not help heavy industry avoid a period of potentially painful adjustment.
Global steel production fell 8% in 2009, even as China increased its output 13.5% to 567.8 million tons. It was a recipe for excess, and the economic downturn meant China couldn’t look outward for a solution.
A global recovery is now in sight, but China still has too much steel. While worldwide demand is growing, the exports that once served as release valves are closing off as international steel capacity comes back online. Adding to China’s troubles, shipping costs to Europe undermine the competitiveness of Chinese steel.
The cement industry faces a similar problem: a largely commoditized product churned out by 4,000 cement plants, with 91.6 million tons of capacity scheduled for closure in 2010 alone.
Much of the overcapacity in China’s heavy industry can be blamed on small, inefficient manufacturers, but industry observers and insiders say there is an opportunity for this to change.
"A period of overcapacity is really the best time to target smaller firms [for consolidation]," said David Fridley, a staff scientist in the China Energy Group at the US Department of Energy’s Lawrence Berkeley National Laboratory (LBL).
Steel and cement are scale businesses, with big firms enjoying advantages both in production and in sourcing raw materials. However, while big cement companies benefit significantly from having large-scale operations within their limestone quarries, the competitive margin for large Chinese steel firms is narrower.
"In the past, the big steel makers have had the advantage of being able to get a better price, but now that advantage is going away," said Scott Laprise, an analyst at brokerage CLSA. Fragmented purchasing – with thousands of buyers in cement and hundreds in steel – has also meant that even small firms can find customers if they cut costs low enough.
A relative lack of differentiation in basic steels means small firms’ products can substitute in many cases for those of their larger competitors. What differentiation exists is typically in high-end steels, such as those necessary for high-speed rail construction, that remain the domain of giants.
"It is a quality issue; only the really big companies have the capability to [produce high-speed rail]," said John Guise, China editor at Steel Business Briefing, an industry consultancy. However, high-speed rail is a limited component of overall steel demand; the need for low-end steels is huge, and competition among small mills is fierce.
Before 2010, the largest firms held the upper hand when negotiating for the coking coal and iron ore that constitute their essential raw materials. Now, the disintegration of traditional iron ore contract negotiations under pressure from large miners like BHP Billiton (BHP.NYSE, BLT.LSE, BHP.ASX), Rio Tinto (RTP.NYSE, RIO.LSE, RIO.ASX) and Vale (VALE.NYSE) has undermined even that position.
The shift from an annual pricing system to the quarterly one engineered by the miners undermines traditional production models for the largest producers. Long-term contracts helped them to benefit from larger discounts when hedging against rising steel prices.
Guise said that while spot prices tend to be relatively higher than quarterly contracts, Chinese mills could abandon their contracts if spot market prices fall below contract prices. "If they can’t guarantee that they’re going to be able to afford the tonnage or they don’t think they need it, they’re going to have to buy it from the spot market," he said.
Smaller firms have less reputational risk if they abandon a contract, and more rapidly adjusting prices means that the cost advantage of China’s biggest producers has a shorter duration. Either way, end customers – including government contractors – are the biggest losers from more volatile prices.
China’s government has tried to rein in overcapacity in the cement and steel industries, favoring larger firms – including behemoths like Baosteel (600019.SH) and Anhui Conch Cement (600585.SH, 0914.HK) – to consolidate production in the hands of a few key enterprises. Beijing’s plan, say analysts, can be broken down into two phases: limiting and consolidation.
"The basic principle is, they don’t want to build any [new plants], but there are certain conditions [in which] these new plants can be built if sufficient backwards capacity is eliminated," said Holcim’s Riley. Limiting also involves imposing minimum production requirements: For cement, this means all new plants must have daily production capacities over 4,000 tons.
This squeezes out smaller firms without the necessary scale, but it also means that at least some of the remaining cement firms will increase their output when they upgrade machinery, exacerbating oversupply. However, since plants can take up to two years to build, the biggest impact of this policy is still years away.
Big and bigger
Attempts to limit steel construction have followed a similar path of imposing production thresholds. Results have been mixed: The government can impose national limits on new production, but the appearance and disappearance of fly-by-night steel manufacturers makes consolidation on a local level considerably more difficult. In particular, integrating local, provincial, and national producers is no easy task, and conflicts at various levels of government impede progress.
"Small steelmakers are feeling nervous, but their actual strength is that they are small, and protected by [local] governments," said CLSA’s Laprise.
China’s most successful steel mergers have been among equals, such as Hebei Iron and Steel’s merger of provincial-level producers. Andrew Dale, Asia head of resources research for Macquarie, described the difficulties national-level producers experienced when they attempted to merge with provincial or local producers. He called the 2005 mega-merger between Angang Steel (0347.HK) and Benxi Steel a failure, with little progress toward integrating the two firms’ operations, Similarly, Dale sees no economic synergies for the recently approved merger of Angang and Panzhihua Iron and Steel, and anticipates more problems as giants try to snap up smaller local producers.
"The easy marriages have been completed now," said Thomas Wrigglesworth, an analyst at Citi.
The natives are restless
Even when deals make economic sense – and despite central government backing – local resistance has proven to be a major obstacle, especially in areas where steel mills are major employers. Small-scale shutdowns and acquisitions have been challenged by workers – sometimes violently – and local governments fear the loss of tax revenues.
Things are considerably easier in cement. "The industry came from a situation six years ago where the top 10 companies only had 2% or 3% of the market," said Holcim’s Riley. "Now that would be 25% and probably on the way to something significantly higher."
For China’s cement manufacturers, acquiring across different geographic areas poses little risk of plant closures. In fact, the high cost of transporting cement makes having plants across provinces and regions an advantage, and buying an existing facility is easier than building from scratch. Cement plants are also usually smaller than steel mills, and that means local people are less likely to stage large uprisings in the event of closure.
The government has one last weapon at its disposal to cull the weakest members of both industries: market forces. As China moves away from the artificially cheap energy that has allowed inefficiency to thrive, rising energy costs will naturally weed out the most outdated and inefficient manufacturers.
In 2006, Beijing initiated a five-year Top 1000 Energy-Consuming Enterprises Program, targeting national enterprises with the highest energy consumption in a bid to cut energy use per unit of GDP by 20% by the end of 2010. Going after these enterprises alone was anticipated to offer 10-30% of necessary energy savings. Steel and cement – which in China lack the more efficient processes of their counterparts in other countries – were listed among the most energy-hungry of China’s industries.
Many of the inefficiencies in steel generation for China’s smaller producers arise from the simple shortage of raw materials. The US has ample supplies of scrap steel to use in more efficient electric arc furnaces, but that’s not an option for China.
"There’s not enough scrap in the world to satisfy Chinese demand," said David Fridley at LBL. As a result, China generates 85% of its steel as primary steel, which Fridley says requires 74% more energy than scrap.
Cement production, meanwhile, suffers from its reliance on coal to generate intermediary materials as well as to mix the final product. Beijing has admitted that 500 million tons of China’s cement production is obsolete or inefficient, requiring more than double the amount of coal per ton of cement as a more modern facility.
This is not to say that drives to push the cement industry to higher levels of efficiency haven’t succeeded. In fact, more than half of China’s cement producers have adopted new kiln designs that are 30% more efficient than older models. An industry-wide turn to waste-heat power generation has also provided a 30% savings over coal power through the use of the process’s own heat to generate electricity. Further innovations in blended cements, and so-called alternative fuels and raw materials – using waste materials as fuel – have also reduced coal usage, said Holcim’s Riley.
These techniques are helping the country reach its energy efficiency goals. According to US Department of Energy models, China will likely reduce its carbon intensity – the amount of carbon produced for each dollar of GDP – to 43% of 2005 levels by 2020. Despite these improvements, it still faces international criticism for its emissions and continues to balance its economic growth goals with the environmental impact of heavy industry.
"The [efficiency] gains are overwhelmed by an absolute increase in production," said Fridley at LBL. But as infrastructure-driven demand reaches its peak, such a breakneck pace of production will not last.
Fortunately for heavy industry, the coming end of the infrastructure boom will also mean the resolution of some of its most pressing environmental and logistical issues. As better infrastructure is put into use, industries will find the process of transporting raw materials and finished products simplified and improved: Rail offers a considerably more energy-efficient alternative to trucks, and where necessary, road transport can benefit from faster and safer new roads.
Minimizing the costs and environmental impacts of transportation and logistics is a positive consequence of China’s infrastructure development and a major impetus for the intense demand for cement and steel.
"[Heavy industry is] a lot more multifaceted than just supply issues – it’s about consistency and delivery availability," said Citi’s Wrigglesworth.
The focus of next month’s special report, China’s logistical networks have long struggled to minimize costs and ensure goods are transported to where they need to be. As the key to infrastructure development, cement and steel have laid the foundation for China’s growth for years to come.